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Watch Out for Broken ETFs

Government action sometimes has unintended consequences.

When the SEC announced last week that it would ban short selling of nearly 800 companies, many applauded the move, hoping that it would mark the bottom of the plunging market. Yet for some ETFs, the measure threatened to put them out of business.

In recent years, fast growth in the ETF industry has spawned a number of innovative investments. Investors can choose sector funds that own stocks in any of dozens of industries. They can invest in funds that invest in commodities of all different kinds, such as natural gas and crude oil. By buying shares of an ETF, you can even buy a share in a stockpile of tons of gold or silver bullion.

But after stocks hit record highs last year, falling share prices brought renewed interest in bear ETFs. These funds give investors a chance to profit when markets drop, as they make investments whose value moves in the opposite direction from the particular indexes they track.

Focusing on financialsFor one bear ETF, the UltraShort Financials ETF(AMEX:SKF) from ProShares, the financial crisis brought unparalleled success. The index it tracks includes companies that span the financial industry, including:

Commercial banks such as US Bancorp(NYSE:USB) and Wells Fargo(NYSE:WFC)

Other types of financial firms, like insurance giant AIG(NYSE:AIG) and credit services firm American Express(NYSE:AXP)

When this financial index falls on a given day, the fund is designed to see its value go up twice as much.

As you can imagine, with many of these companies on the ropes recently, it would've been hard to find a better bet than the UltraShort Financials fund. Between May 2007 and July 2008, the fund's shares tripled. Yet the ETF has also been volatile on the downside -- since the government bailout of Fannie Mae and Freddie Mac in July, the fund has lost half its value.

A big problemHowever, last week's prohibition of short selling of financial firms threw the fund into chaos. For a brief period after the SEC announcement last Friday, shares of the ETF stopped trading as ProShares, and investors tried to figure out what impact the anti-short-selling measure would have on the fund. On one hand, if the ETF were able to keep following its investing strategy, investors would effectively be able to bypass the short-selling prohibition. It was unclear whether the ETF would even be able to make the investments necessary to follow its strategic mandate.

Since then, the fund has behaved erratically. Look at its daily returns:

Day

Financials Index Return

UltraShort Financials Return

Sept. 19

9.1%

(13.4%)

Sept. 22

(6.0%)

2.0%

Sept. 23

(1.3%)

2.1%

Sept. 24

(1.0%)

1.7%

Total

0.2%

(8.3%)

Source: Yahoo! Finance.

Even on a daily basis, the ETF has stopped tracking its index. And when you add up the four trading days since the ban, the ETF is down sharply, despite almost no change in the underlying index.

An uncertain outcomeIronically, the same liquidity problems that led to problems in financial stocks -- and the ETF's profits -- appear to be causing the fund to malfunction. ProShares has stopped creating new blocks of ETF shares for institutional investors because of its concerns about the restrictions keeping it from creating new short positions. Although existing ETF shares still trade on the secondary market, their price doesn't necessarily track the actual value of the ETF's assets -- as it normally would if new blocks of shares were readily available.

Several clouds still lie on the ETF's horizon. If the short-selling prohibition is allowed to expire as scheduled on October 2, it's possible that the fund will again experience wild swings, especially if it resumes creating new blocks of shares. Some believe that the boost financials got immediately following the short-selling ban will be followed by a dramatic drop -- and therefore expect that the ban will be extended past October 2.

Just as the mortgage crisis has been eye-opening in revealing how incomprehensibly complex certain asset-backed securities have become, this episode for the UltraShort Financials ETF shows that investors can't always expect their investments to perform exactly as they'd expect -- even when they're performing well. As ETFs get more complicated, make sure you understand how they work before the unexpected happens.

To follow all the developments with mutual funds and ETFs, tune in to ourMotley Fool Champion Fundsnewsletter. Lead advisor Amanda Kish tells readers which funds to buy and which to avoid every month. We'll even give you a free look with a 30-day trial.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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